Principal risks and uncertainties

Set out below is our assessment of current principal risks and uncertainties. A detailed review of the group’s inherent risk exposures and high level control processes are set out at Note 8, Note 19 and Note 29 of the financial statements.




Reserves for long-term business may require revision as a result of changes in experience, regulation or legislation. The writing of long term insurance business requires the setting of assumptions for long term trends in factors such as mortality, lapse rates and persistency, valuation interest rates, expenses and credit defaults. Actual experience may result in the need to recalibrate these assumptions reducing profitability. Forced changes in reserves can also be required because of regulatory or legislative intervention in the way that products are priced, reducing profitability and future earnings.

We regularly appraise the assumptions underpinning the business that we write. In our annuities business we are, however, exposed to factors such as dramatic advances in medical science beyond those anticipated leading to unexpected changes in life expectancy. In protection business we remain inherently exposed to rates of mortality diverging from assumptions and to loss from events that cause widespread mortality/morbidity or significant policy lapse rates. As illustrated by the implementation of the EU gender neutral pricing legislation, there is also potential for legislative intervention in the pricing of insurance products irrespective of risk factors, such as age or health.

We undertake significant analysis of longevity and mortality risks to ensure an appropriate premium is charged for the risks we take on and that our reserves remain appropriate. We remain focused on developing a comprehensive understanding of annuitant mortality and we continue to evolve and develop our underwriting capabilities. The sensitivities of our business to a range of scenarios are set out in Note 21. We seek to ensure that legislators understand the benefits to consumers of pricing insurance products based on the risk factors that each policy presents.

Investment market performance or conditions in the broader economy may adversely impact our earnings and profitability. The performance and liquidity of investment markets, interest rate movements and inflation impact the value of investments we hold in shareholders’ funds and those to meet the obligations from insurance business. Interest rate movement and inflation can also change the value of our obligations. We use a range of techniques to manage mismatches between assets and liabilities. However, loss can still arise from adverse markets. In addition, significant falls in investment values can reduce fee income to our investment management business, while broader economic conditions can impact the purchase and the retention of retail financial services products, impacting profitability.

Whilst global investment markets have returned to pre-financial crisis levels, in the current environment there is limited resilience in financial markets for shocks, with potential for significant falls in asset values should markets reassess returns. Factors that may result in shocks include a deterioration in geo-political stability for example as a consequence of tensions in Eastern Europe and the Middle East; an abrupt change in the monetary policies of the leading economies; or a further crisis in the Euro zone. Financial markets may also reappraise asset valuations as a result of changes in the outlook for the global economy including for example, a projected period of low or negative growth amongst leading economies or a period of prolonged deflation, and in response to outcomes from elections in the UK, Europe and the US.

We model our business plans across a broad range of economic scenarios and take account of alternative economic outlooks within our overall business strategy. As part of our business plans we have sought to ensure focus upon those market segments that we expect to be resilient in projected conditions. Details of our business strategy are set out in the Response to macro trends section. Sensitivities to interest rates, exposure to worldwide equity markets and currencies are set out in Note 17, Note 21 and Note 30 respectively.

In dealing with issuers of debt and other types of counterparty the group is exposed to the risk of financial loss. A systematic default event within the corporate sector, or a major sovereign debt event, could result in dislocation of bond markets, significantly widening credit spreads, and may result in default of even strongly rated issuers of debt, exposing us to financial loss. We are also exposed to banking, money market and reinsurance counterparties, and settlement, custody and other bespoke business services, a failure of which could expose us to both financial loss and operational disruption of our business processes.

Recent years have seen a narrowing of credit spreads reflecting market confidence in the issuers of investment grade bonds, and at Legal & General we have continued to experience low levels of default on our corporate bond portfolio. There remains, however, a range of factors that could trigger defaults by the issuers of debt, leading to reduced profitability or financial loss. These include a sovereign debt event or a banking crisis developing, for example in emerging markets. An economic shock or significant change in the current economic outlook may also increase potential for a supplier of business services being unable to meet their obligations to us.

We actively manage our exposure to default risks, setting counterparty selection criteria and exposure limits and hold reserves against our assessment of counterparty debt defaults. We continue to diversify the asset classes backing our annuities business, to include the use of property lending, sale and leaseback and other forms of direct investment. Exposures to credit risk are set out in Note 17 and sensitivities to changes in credit spreads in Note 21.

Changes in regulation or legislation may have a detrimental effect on our strategy. Legislation and government fiscal policy influence our product design, the period of retention of products and our required reserves for future liabilities. Regulation defines the overall framework for the design, marketing and distribution of our products; and the prudential capital that we hold. Significant changes in legislation or regulation may reduce our future revenues and profitability or require us to hold more capital. The prominence of the risk increases where change is implemented without prior engagement with the sector. The nature of long term business can also result in some changes in regulation, and the re-interpretation of regulation over time, having a retrospective effect on our in-force books of business, impacting the value of embedded future profits.

The regulatory landscape continues to evolve. The Solvency II capital regime is to be implemented by the PRA on 1 January 2016; the FCA is continuing to develop its approach to consumer regulation; and we continue to see new regulation emerging from the EU. More broadly, as illustrated in the 2014 budget announcement, the sectors in which we operate remain inherently exposed to sudden changes in legislation and regulation. With regard to Solvency II, the capital that we will be required to hold will not be certain until PRA agreement of our internal model, with the risk that the final outcome results in a lower capital surplus than under Solvency I. There are also challenges in ensuring that regulatory interpretation of the new rules is proportionate and cost effective for the insurance sector. In terms of consumer regulation, there remains a need for greater regulatory certainty to providing consumer guidance and addressing the advice gap in a post Retail Distribution Review and an increasingly digital world.

We remain vigilant to the risk that future legislative and regulatory change may have unintended consequences for the sectors in which we operate. We seek to actively participate with Government and regulatory bodies in the UK and Europe to assist in the evaluation of change so as to develop outcomes that meet the needs of all stakeholders. Internally, we evaluate the impact of all legislative and regulatory change as part of our formal risk identification and assessment processes, with material matters being considered at the Group Risk Committee and the Group Board. We maintain a flexible distribution model to respond to changing market trends.

As a UK based group, our earnings are influenced by the performance and perception of the UK financial services sector as a whole. The financial crisis, subsequent investment performance and low interest rate environment, together with regulatory actions in the sector, may impact consumer attitudes to long term savings and insurance products. Regulatory actions may also lead to changes to the regulatory and legislative environment in which we operate.

As a significant participant in the long term savings and insurance markets, we are exposed to changes in consumer sentiment. We are also exposed to increased costs of regulatory compliance through regulatory and legislative responses to events in the financial services sector. Recent examples include requirements for central clearing of certain derivative instruments, which would increase the costs associated with pension savings products and annuities, respectively.

We actively manage our brand and seek to differentiate our business model from that of our competitors, focusing on our customers’ needs through a diversified portfolio of risk, savings and investment businesses. We also actively engage with our regulators to support understanding of the risk drivers in the markets in which we operate, and highlight matters where we believe the industry needs to change.

The group may not maximise opportunities from structural and other changes within the financial services sector, adversely impacting future earnings. Significant changes in the markets in which we operate may require the review and realignment of elements of our business strategy. A failure to be sufficiently responsive to potential change and understand the implication to our businesses, or the incorrect execution of change may impact the achievement of our strategic objectives.

Macro trends in the markets in which we operate remain those of an ageing population; reform in the provision of state welfare; retrenchment by the banks; the globalisation of asset markets; and the increasing use of digital technologies. Responding to these trends potentially creates people and change risks, such as organisational challenges and management stretch across the range of initiatives. As set out in the 5 Macro trends section, regulatory changes and political risks may also present complexity in delivering our responses.

As set out in the Progress on strategy section, we’ve defined clear strategies to respond to the macro trends. We monitor as part of our ongoing risk review processes, factors that may, impact our responses to these macro trends and seek to ensure appropriate risk mitigation plans are put in place.

A material failure in our business processes may result in unanticipated financial loss or reputation damage. We have constructed our framework of internal controls to minimise the risk of unanticipated financial loss or damage to our reputation. However, no system of internal control can completely eliminate the risk of error, financial loss, fraudulent actions or reputational damage.

Our plans for growth inherently will increase the profile of operational risks across our businesses. We continue to invest in our system capabilities and business processes to ensure that we meet the expectations of our customers; comply with regulatory, legal and financial reporting requirements; and mitigate the risks of loss or reputational damage from operational risk events.

Our three lines of defence risk governance model seeks to ensure that business management are actively engaged in maintaining an appropriate control environment, supported by risk functions led by the group chief risk officer, with independent assurance from Group Internal Audit. The work of the Group Audit Committee in the review of the internal control system is set out in the Letter from the Chairman of the Audit Committee.

The financial services sector is increasingly becoming a target of ‘cyber crime’. As we and our business partners increasingly digitalise our businesses, we are inherently exposed to the risk that third parties may seek to disrupt our online business operations, steal customer data or perpetrate acts of fraud using digital media. A significant cyber event could result in reputation damage and financial loss.

The financial services sector continues to see attempts by third parties to seek and exploit perceived vulnerabilities in IT systems. Potential threats include denial of service attacks, network intrusions to steal data for the furtherance of financial crime, and the electronic diversion of funds.

We’re focused on maintaining a robust and secure IT environment. Working with our business partners, we seek to ensure the security of our systems with proactive responses to emerging threats, however, the evolving nature of cyber threats means that residual risks will remain. During 2014 the Group Risk Committee received an update on cyber risks and our control framework.